Based on the research of

Based on the research of

Say you are an executive of a company desperate to meet market expectations. If you meet them, your stock options hit their strike price—but it looks like the firm’s performance is going to come up short. You could make a last-ditch effort to enter a new market, but it’s risky. Under other circumstances, you would never consider it. Do you go for it anyway?

Or consider that you are a portfolio manager who receives generous bonuses for strong performance, but pays nothing out of pocket for generating losses. Do you opt to sell mortgage-backed securities or credit default swaps, which have an extremely high probability of turning out favorably—but a small probability of blowing up the firm?

In both of these cases, you just might. After all, if the gamble fails, you are not much worse off. Your stock options are still worthless; your bank account balance is preserved. And if the gamble succeeds, terrific!

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As a way to motivate everyone from salespeople to CEOs, organizations often disproportionately reward performance above a specified threshold.

For employees, “the idea is that increasing output a little bit gives me a lot relative to losing output,” says Dan Barron, an assistant professor of strategy at the Kellogg School.

But a recent study by three Kellogg School researchers—Barron, George Georgiadis, an assistant professor of strategy, and Jeroen Swinkels, a professor of strategy—suggests that simple contracts that reward performance proportionately, thus doing away with a magical threshold, may offer a better way of aligning employees’ incentives with those of the company.

And the benefits could reach beyond firms.

“Those types of incentive structures were a key driver of excessive risk-taking, which led to the financial crisis,” says Georgiadis. “So thinking about the incentive contracts that deter this kind of risk-taking behavior is important.”

Motivated to Game

The reasoning behind incentive schemes with a “threshold” feature makes intuitive sense: What company wouldn’t want to use the lure of a huge payoff to eek out extra effort from employees?

Risk-taking is an “inevitable part of any profit-making venture. What we want you as an employee to do is take on smart risks.” —Dan Barron

But there is a potential problem: gaming. Employees who game a contract are, in a sense, allowed to reap rewards while putting forth less effort than the contract intended.

“They don’t have to work as hard to make their quotas. If they happen to fall short, you just take on a little bit of risk,” says Barron. “Why would I want to exert all the hard work that it takes to actually shift output up when I can instead just take a little gamble and I’ll probably end up okay anyway?”

So what kind of incentive scheme cannot be gamed, but still motivates employees to work hard?

Related

To find out, the researchers built a mathematical model to explore how employees might behave under various contracts. (The research falls under “contract theory,” the same discipline for which the most recent Nobel Prize in economics was awarded.)

“How can the firm ensure that, when the time comes for an employee to make the decision about how to behave, his incentives are aligned with the firm’s?” asks Georgiadis.

They found that a simple or “linear” contract is generally best. This means that the reward offered is directly proportional to how an employee performs and the risks that she takes. There is no threshold to game: a CEO is compensated equivalently for the same rise in profits regardless of whether the firm barely hits or barely misses its target.

The researchers also looked at a third type of contract, where performance below a threshold is disproportionately punished. They found that while it does not encourage gaming, it also does not adequately reward strong performers. If an employee only has to perform adequately to receive a reward, why would he bother working harder, or taking even a smart risk?

“Linear contracts are optimal. They provide the strongest powered incentives that do not induce gaming,” says Barron.

Importantly, linear contracts neither encourage nor discourage actual risk-taking—an “inevitable part of any profit-making venture,” says Barron. “What we want you as an employee to do is take on smart risks.”

In other words, risks that are not driven by gaming.

Other Applications

Linear contracts can ward against a second kind of gaming as well—one that, the researchers found, is mathematically equivalent to risk-taking: shifting output across time.

Say, for instance, you are a salesperson looking to meet your quota for July. It is the last day of the month, and you are just one sale short of a huge bonus. How steep of a discount are you willing to offer the next customer through the door—if she signs the paperwork today?

“It’s ultimately the same kind of gaming,” says Barron. Why should a salesperson put in the effort to sell more cars all month long when a steep discount on July 31st can result in the same reward? A linear contract, which stipulates the same commission regardless of when a car is sold, would eliminate this incentive.

The researchers note that sometimes these two types of gaming can work in tandem.

“What CEOs sometimes do,” says Georgiadis, “is they see they’re going to miss their earnings targets, and then they cut maintenance, or R&D projects, or some investments on this or that, or training expenses. By doing this, they meet the targets—but they’re really shifting output earnings across time, because they’ll have to do that maintenance at some point. And at the same time, they’re shifting risk, in the sense that if I cut maintenance, that means there is a higher chance of a disaster happening.”

Contracts that incentivize gaming can affect more than individual organizations; they can affect the broader economy. For instance, plenty of experts have linked the financial crisis in 2008 to “perverse incentives for bankers and portfolio managers,” says Georgiadis. “ were giving them very strong incentives if they made money, and if they lost money, they didn’t have to pay anything out of pocket.”

“On top of that,” says Georgiadis, “they would get a bonus if their performance was above a threshold. That kind of incentive scheme is exactly what induces ‘selling insurance’—basically taking huge left-tail risks, which is what we saw happened with those credit default swaps and mortgage-backed securities.”

“The same kind of contracts that are going to deter the bad kind of risk-taking from the firm’s perspective also potentially can be used to deter the bad kind of risk-taking from society’s perspective,” says Barron.

Advice for Organizations

How can companies know whether their incentive schemes are likely to be gamed by employees? There are no hard and fast rules, say the researchers.

“It’s difficult to infer from outcomes that this gaming is going on,” says Barron. He advises companies to “look at the incentives that are offered, and put your feet into your very evil brother. How would you game those incentives?”

As a firm, says Georgiadis, “if you are worried about gaming, then a linear contract is generally a good idea. It’s not always a good idea, and there are caveats: our model is not the world. But a linear contract is a good idea.”

“What I would like people to take away more than anything else is an awareness of the kinds of gaming that people can do and the kinds of incentive schemes that encourage that gaming,” says Barron. If, at the end of the day, companies understand that a bonus scheme is going to encourage gaming—and they offer it anyway—then fine. “But don’t do it and then later realize, ‘oops, we introduced a lot of gaming that we weren’t expecting.’ At least walk into that trap with your eyes open.”